Capital Markets Advisors

February 4th, 2014

In Europe’s answer to the US Volcker Rule, the European Commission recently published a consultation paper that proposes limits on proprietary trading. How do the two regulatory approaches compare?

One of the most important parts of the Dodd-Frank Act (DFA) is Section 619, known as the Volcker Rule (VR). Although the rest of the G20 countries have been implementing parallel regulations to much of the DFA, especially Title VII on derivatives, nobody else had begun working on regulations prohibiting proprietary trading or owning hedge or PE funds – until now.

On January 29 the European Commission published a consultation paper called “on structural measures improving the resilience of EU credit institutions.” Following on the Liikanen Report, this document is Europe’s answer to the VR, (I’ll call it the EU VR, for now) and thus merits a careful comparison to the final VR in the area of proprietary trading. We have to bear in mind, of course, that this is a consultation document, the equivalent to a proposed rule in the US, and so it may be substantially changed before it is finalized; but let’s see how it compares.

The Approaches

The first comparison, and the most important, is the respective approaches. The US VR has a very simple definition of proprietary trading – taking positions in a certain set of instruments for the bank’s account – and simply prohibits it. Then it lays out a series of exemptions, the most important four of which are: liquidity management, underwriting, market-making, and hedging. If a trade doesn’t fall under one of the exemptions, it’s simply prohibited. Each of the exemptions is carefully delineated in the final document, both in the rule itself and in the preamble.

[Related: “Did You Forget About the Volcker Rule? – Part 2: Exemption Requirements”

The EU VR takes a somewhat different approach in defining proprietary trading as …

“… using own capital or borrowed money to take positions in any type of transaction to purchase, sell or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity’s risk as result of actual or anticipated client activity, through the use of desks, units, divisions or individual traders specifically dedicated to such position taking and profit making, including through dedicated web-based proprietary trading platforms.” (emphasis added)

So the first thing to note is that the EU attempted to incorporate the hedging, market-making (and perhaps underwriting) exemptions into the definition of proprietary trading. As a result, there are no exemptions with criteria and measurements. However, almost immediately the EU VR does indicate that:

“The prohibition … shall not apply to:

• (a) financial instruments issued by Member States central governments or by entities listed in point   (2) of Article 117 and in Article 118 of Regulation (EU) No 575/2013;

• (b) a situation where an entity referred to in Article 3 meets all of the following conditions:

• (i) it uses its own capital as part of its cash management processes;

• (ii) it exclusively [deals in] cash or cash equivalent assets. Cash equivalent assets must be highly liquid investments held in the base currency of the own capital, be readily convertible to a known amount of cash, be subject to an insignificant risk of a change in value, have maturity which does not exceed 397 days and provide a return no greater than the rate of return of a three-month high quality government bond.”

So trading in EU government bonds and liquidity management appear to be allowed.

 Who is Affected?

And who falls under this EU VR? According to Article 3:

“Any credit institution or an EU parent, including all branches and subsidiaries irrespective of where they are located, when it is identified as a global systemically important institution, and any of the following entities that for a period of three consecutive years has total assets amounting at least to EUR 30 billion and has trading activities amounting at least to EUR 70 billion or 10 per cent of its total assets.

• (i) any credit institution established in the Union which is neither a parent undertaking nor a subsidiary, including all its branches irrespective of where they are located;

• (ii) an EU parent, including all branches and subsidiaries irrespective of where they are located, where one of the group entities is a credit institution established in the Union;

• (iii) EU branches of credit institutions established in third countries.”

I’m sure you are saying right now, “That means just about everyone, including some firms falling under the US VR!” So the EC added some exclusionary language. To wit:

“This Regulation shall not apply to:

• (a) EU branches of credit institutions established in third countries if they are subject to a legal framework deemed equivalent in accordance with Article 27(1);

• (b) subsidiaries of EU parents established in third countries if they are subject to a legal framework deemed equivalent inaccordance with Article 27(1).”

And Article 27(1) describes:

• “(a) the legal, supervisory and enforcement arrangements of a third country [that] ensures that credit institutions and parent companies … comply with binding requirements which are equivalent to the requirements laid down in Articles 6, 10 to 16 and20;

• (b) the legal framework of that third country [that] provides for an effective equivalent system for the recognition of structural measures provided under third-country national law regimes.”

What It Means

There is lots more to the EU VR, of course (the whole thing, with preamble, is 65 pages), but we can draw a few conclusions from these brief excerpts.

1. The prohibition specifically says that proprietary trading is “for the sole purpose of making a profit for own account,”which is very different from the US VR prohibition. One might conclude that trading for the purpose of making a profit from market-making and/or underwriting would be allowed, as long as it serves those customer-oriented purposes; but we probably won’t know that for sure until the final regulation is issued, if then.
2. The liquidity management exemption is worded differently from the US VR. Here, the investments must be in “in the basecurrency of the own capital,” be no longer in maturity than about a year, and, strangely, “provide a return no greater thanthe rate of return of a three-month high-quality government bond.” That last provision is apparently an attempt at risk control, but I could think of several ways to do it more effectively – especially since some of the government bonds allowed under the exemption wouldn’t qualify as high quality.
3. The inclusion/exclusion language is a bit cumbersome and leaves US subsidiaries of EU banks somewhat up in the air, at least until the regulator of the parent rules that US regulations are comparable. And what happens if an EU national regulator that had deemed US regulations to be comparable changes its mind?